Financial reinsurance

Charles McLeodSeptember 2002

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Agenda

1) What is financial reinsurance?2) A brief history in other countries3) Why do companies use financial

reinsurance?4) How does it work?5) Some benefits of financial

reinsurance

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1. What is financial reinsurance?

No legal or regulatory definition in most countries.

Traditional reinsurance > Focused on risk management through

the transfer of risk. Financial reinsurance

> Primary objective is the achievement of a specific business goal, e.g. improve ROE, reduce capital requirements.

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What is financial re. (cont’d)?

Financial reinsurance tools are mainly the same as for traditional reinsurance – the difference is why and how they are used.

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Some general observations

1. Financial reinsurance often relies on the ceding company and the reinsurer being subject to different:> Accounting rules> Regulatory practices> Tax regimes> Profit measures or motives, etc

2. Don’t play games with the regulators!

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Trouble in the U.K. – 6 August 2002

“The UK's insurance industry watchdog has warned firms not to use reinsurance contracts as a way of misleading policyholders on the true state of their balance sheets. In a discussion document, the Financial Services Authority (FSA) acknowledged that financial engineering of balance sheets was perfectly legitimate in many cases. However, it warned of instances where controversial methods of bolstering balance sheets might be used to mislead policyholders - or even the regulator itself. "Financial engineering may threaten the actual financial resources of a firm or create a false impression of financial strength", the FSA noted.”

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2. History of financial reinsurance

Started in North America in late 1970’s. Initially driven by desire to reduce

surplus strain on new business, and to reduce taxes.

Its use increased as companies started recognizing the cost of required capital when pricing products.

Demutualization of some large companies has resulted in a further increase in use.

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History (continued) In Canada, 60% of new business

was reinsured in 2000. The ratio increased to 75% in 2001!

Some very large companies are reinsuring up to 90% of their new business.

Trends are similar in the USA.

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History (continued) Financial reinsurance is not as

common in other countries as in North America.

Countries where financial reinsurance is used include the U.K., Hong Kong, Japan, Taiwan and Mexico.

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3. How can financial reinsurance help

companies? Reduce surplus strain/cost of writing

new business. Reduce required capital/increase

actual capital Improve the level and timing of

earnings Improve the stability of earnings Improve the level of IRR, ROE, etc. Manage income taxes

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4. How does it work? Reinsurer’s capital used instead of

the ceding company’s capital and/or Conservative valuation assumptions

replaced with competitive reinsurance rates and/or

The reinsurer advances part of the future profits of new business or in-force insurance business – so that income is recognized sooner.

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How does it work (continued)?

As a result, the ceding company can:> Improve its IRR or ROE> Finance its surplus strain/cost of

writing new business> Reduce its required capital/increase

actual capital> Manage its taxable income

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Some definitions

Yearly Renewable Term (YRT) reinsurance

Coinsurance Coinsurance funds withheld

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YRT reinsurance

Simplest type of reinsurance Ceding company pays reinsurer a premium

to cover reinsured death (or disability) claims.

Reinsurer pays only death (or disability) claims, and does not pay other benefits such as surrender benefits.

Required capital for ceding company reduces because it has transferred some risks to reinsurer.

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Coinsurance Shares all risks with the reinsurer Assume 50% of business is coinsured (quota

share). Ceding company pays reinsurer 50% of

premiums paid by policyholders. Reinsurer pays ceding company 50% of ALL

benefits paid to policyholders (not just death claims).

Reinsurer pays an allowance/ceding commission to cover ceding company’s expenses.

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Coinsurance (continued)

Reinsurer holds reserves for its share of business.

Not used often (except for products, such as term insurance, with low reserves) because:

> Ceding company “loses” assets> In some countries, ceding company

still has to hold reserves for 100% of business

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Coinsurance - funds withheld

Same as coinsurance except that:

Ceding company keeps assets backing reserves.

Ceding company credits reinsurer with investment income on assets/reserves for the business reinsured.

( A variation of this is “modified coinsurance”)

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Coinsurance – impact on solvency margin ratio of

ceding company

Required capital decreases – because some risks have been transferred to reinsurer.

Actual capital increases - because of allowances/commissions paid by reinsurer.

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A simple example

Block of single premium non-participating (without profits) life insurance

Acquisition expenses equal to 5% of single premium

All numbers on pre-tax basis

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Simple exampleStatutory results before reinsurance

(First five years only shown)

Year Reserve

Premium

Invest.income

Benefits and

expenses

Change in

reserves

Statutory

earnings

Required

Capital

Inv. Inc.on

Req’dCapital

Distrib-utable

earnings

0 100.0 100.0 - 5.0 100.0 (5.0) 5.0 - (10.0)

1 100.0 - 7.0 6.3 (0.0) 0.7 5.0 0.3 1.1

2 99.7 - 7.0 6.4 (0.3) 0.9 5.0 0.3 1.3

3 99.2 - 7.0 6.5 (0.5) 1.0 5.0 0.3 1.4

4 98.6 - 6.9 6.5 (0.6) 1.1 4.9 0.3 1.4

5 97.9 - 6.9 6.5 (0.7) 1.1 4.9 0.3 1.5

Value of business

7.2 IRR 14.6%

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Improving IRR

Insurer

Reinsurer

Coinsurance (funds withheld) of 50% of business with full risk transfer

Initial cashallowance paid equal to embedded value of business reinsured

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Improving IRRStatutory results after reinsurance

(first five years only shown)

Year

Reserve

Premium

Initial

allow-ance

Invest.

income

Benefits and

expenses

Changein

reserves

Statearn.

Req’dcapita

l

Inc. onreq’d

capital

Distrib-utable

earnings

0 50.0 50.0 3.6 - 5.0 50.0 (1.4) 3.8 - (5.2)

1 50.0 - 3.5 3.1 (0.0) 0.4 3.7 0.3 0.6

2 49.9 - 3.5 3.2 (0.1) 0.4 3.7 0.3 0.7

3 49.6 - 3.5 3.3 (0.3) 0.5 3.7 0.3 0.8

4 49.3 - 3.5 3.3 (0.3) 0.5 3.7 0.3 0.8

5 49.0 - 3.4 3.3 (0.4) 0.5 3.7 0.3 0.8

IRR 15.7%

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Key Points Reinsurer has paid an initial

allowance equal to full embedded value of 50% of business.

In return for its share of all future premiums, the reinsurer agrees to its share of all future claims.

Reinsurer’s capital replaces part of ceding company’s capital.

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Financing acquisition costs

Insurer

Reinsurer

Coinsurance (funds withheld) of 50% of business without full risk transfer.

Repayment expected in five yearsInitial cash

allowance paid equal to a smaller portion of embedded value ofbusiness reinsured

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Financing acquisition costsStatutory results after reinsurance

(first five years only shown)

Year

Premium

Initial

allow-ance

Invest.

income

Benefits

andexpens

es

Riskfee

Changein

reserves

Statearn.

Req’dcapita

l

Inc. on

Req’d

Cap

Dist.Earn.

Deficitaccount

0 50.0 1.8 - 5.0 - 50.0 (3.2) 3.8 - (7.0) 1.8

1 - - 3.5 3.1 0.2 (0.0) 0.2 3.7 0.3 0.5 1.6

2 - - 3.5 3.2 0.1 (0.1) 0.3 3.7 0.3 0.6 1.3

3 - - 3.5 3.3 0.1 (0.3) 0.4 3.7 0.3 0.7 0.9

4 - - 3.5 3.3 <0.1 (0.3) 0.5 3.7 0.3 0.8 0.4

5 - - 3.4 3.3 >0.0 (0.4) 0.5 3.7 0.3 0.8 repaid

IRR 15.9%

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Two new conceptsDeficit account – this equals: Initial allowance, less Statutory earnings on reinsured

business

Risk fee Expressed as a percentage of deficit

account Paid to reinsurer

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Key Points Reinsurer has paid lower initial

allowance since it expects to be repaid for financing provided within 5 years.

When financing is repaid, the ceding company can recapture the business from the reinsurer (without penalty). > Thereafter all risks and rewards return to

the ceding company. Initial allowance acts like debt.

> But unlike debt, allowance acts as additional capital since repayment is contingent on profitability of business.

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Reducing required capital

Each of the previous examples resulted in a reduction in the required capital.

The largest reduction in capital occurs through reinsuring a large percentage of the business, and by using coinsurance to transfer reserves.

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Manage taxable income Suppose the ceding company has a tax

loss carryover due to expire. An initial cash allowance is paid as

previously.> Amount determined so that any expiring tax

loss carryover is utilized.> Full amount advanced is not taxable

(sheltered by tax loss carryover). In subsequent years, when ceding

company is taxable, reinsurance financing is repaid on a tax deductible basis.

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Using reinsurance to manage expiring tax losses

(results for all years shown)

Year Pre-taxincome

Expiring

TLCF

Tax Post-tax

income

Unused

TLCF

Reins.Allowan

ce

Pre-taxincome

Tax Post-tax

income

1 (15) 10 - (15) 10 25 10 - 10

2 (8) 13 - (8) 13 21 13 - 13

3 2 17 - 2 15 15 17 - 17

4 11 10 - 11 - 4 15 2 13

5 21 5 6 15 - (6) 15 3 12

6 36 - 13 23 - (16) 20 7 13

7 41 - 14 27 - (16) 25 9 16

8 45 - 16 29 - (17) 28 10 18

9 48 - 17 31 - (18) 30 11 20

10 50 - 18 33 - (19)p.v. = 0

31 11 20

Before reinsurance After reinsurance

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Post-Tax Income Comparison

(20)

(10)

-

10

20

30

40

1 2 3 4 5 6 7 8 9 10

Before Reins. After Reins.

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Summary – uses of reinsurance

Finance acquisition cost strain> Reduce cost of writing new business;

improve offers for acquisition targets Reduce required capital/increase actual

capital Improve the level and timing of earnings Improve the stability of earnings Improve the level of IRR and ROE Manage income taxes

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5. Benefits of reinsurance

Simpler and faster to implement than other structures

Confidential Competitive pricing/low

transaction costs Access to reinsurer’s expertise Flexibility of duration Flexibility of size Flexibility of structure

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Any questions?